Gap Inc. (NYSE: GPS) reported Q4 and full-year results that beat expectations after a downward guidance revision prior to releasing Q3 results.

Quarterly revenue came in at $4.7 billion, up 3% compared to the consensus estimates of $4.56 billion. Earnings per share of $0.58 beat consensus estimates of $0.41, a 41% difference. On the full year, Gap beat its revised EPS guidance by 14% from the midpoint.

Year over year, Gap’s quarterly revenues have risen 2%, while earning per share decreased 20%. This is largely on the back of struggling sales from their staple brands Gap, Old Navy, and Banana Republic.

Management released EPS guidance of $1.80-1.92, beating analyst estimates of $1.69. However, they note it includes only marginal effects of the coronavirus, excluding anything that effects in the United States. Given how quickly the virus is progressing, it’s hard to imagine this will be met.

While the stock has jumped initially after hours, we don’t expect the name to outperform in the coming weeks. We believe investors are eager for any good news.

Uncertainty Added to Already Uncertain Times

Earlier in January, Gap announced they would be cancelling the spin out of their Old Navy business into its own public company. While investors reacted positively at the time due to the expected cost savings, Gap’s overall stock performance compared to peers has been terrible over the last year.

Stock Price Performance

Source: YCharts.

The spin-out cancellation was likely in part due to the departure of CEO Art Peck and understanding the added complexity of turbulent leadership would inhibit a positive result for the spin-out.

Some more clarity was provided at the beginning of March when Gap announced they found a successor in Sonia Syngal, an accomplished retail leader and CEO of its Old Navy business.

Unfortunately for Syngal, she’s taking over at a time when their brand portfolio is struggling. Further, sales at Old Navy didn’t appear to be trending in the right direction either.

At a minimum, the company understands its brands fail to connect with consumers, they have also noted decreasing foot traffic as a challenge. Given the recent societal push for “social distancing” in the wake of the coronavirus, Gap is unlikely to find any reprieve.

On the bright side (if there is such a thing these days), the company’s balance sheet appears to be able to weather a storm, with minimal meaningful drags from debt.


Terrible Tale of the Tape

Savvy investors know that struggling companies can present the best value-opportunities. However, it’s important to first step back and look at the bigger picture.

From a forward-valuation perspective, Gap is the cheapest among its peers as investors have seemingly priced in the company’s recent struggles. While this might suggest they are a potential value-buy, it’s important to take a look under the hood at operations and profitability.

Forward PE Ration (1-Year)

Source: YCharts.

Looking at general operational performance, investors can see that Gap’s YoY revenue growth has gone negative at a time when many of their peers continue to push higher.

Quarterly YoY Revenue Growth

Source: YCharts.

With downward revised guidance, this poor performance comes as no surprise to investors. But it is a warning sign that their flagship brands in Gap, Old Navy, and Banana Republic are facing serious challenges.

Unfortunately for Gap, it appears they have little wiggle room to try and improve sales. EBIT margins are effectively tied for the lowest in their peer group.

With the coronavirus likely to hurt sales in Q1 and Q2 of 2020 (at the very least), this trend will not change in the short-term. Beyond this damage, investors should look for clear signs of a brand turnaround like new (capable) leadership or sustained sales increases before investing.

The second important metric is profitability. Unfortunately for Gap, it appears they have little wiggle room to try and improve sales. EBIT margins are effectively tied for the lowest in their peer group.

This means any attempts at promotional campaigns or increases in the sales and marketing budgets will need to yield immediate results, else this will decrease further, hurting shareholder returns.

EBIT Margin

Source: YCharts.

In conclusion, Gap sales were already struggling, and now a recessionary macro environment has been layered on top. While already depressed valuation is intriguing, low EBIT margins and an inability to connect with consumes drag the story down.  There is no reason to believe Gap’s performance will improve for the first half of 2020. Investors should stay clear until the company shows it can connect with consumers and drive sustainable sales.

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